Can This Troubled LNG Project Still Deliver for Chevron, ExxonMobil, and Royal Dutch Shell?

Australia's Gorgon LNG is one of the largest liquefied natural gas projects in the world. When complete, the Gorgon is expected to produce 15.6 million metric tons of LNG a year and last for 40 years. For Australia, the Gorgon was supposed to add hundreds of billions of dollars to Australia's GDP and employ thousands of people. For the companies that invested, Gorgon was supposed to be one of the cornerstones of their LNG portfolios and deliver long-lasting shareholder value.

However, Gorgon has experienced substantial setbacks. Because of its geography, located 60 kilometers off of Australia's coast, the engineering challenges associated with the megaproject have been enormous, and Gorgonis $17 billions of dollars over budget, with an estimated cost of $54 billion versus the originally anticipated $37 billion.The project also recently ran into some mechanical issues in Train 1 that might cost operator Chevronan additional $50 million to $100 million to fix and cost its owners an opportunity cost of $250 million to $300 million in delayed revenues. With its costs growing, can Gorgon still deliver value?

Outlook not as bright as originally planned

When the final investment decision was made for Gorgon in 2009, the outlook for LNG was bright. China was growing furiously and needed clean energy for its environment. Other nations with major economies but few energy resources also needed natural gas. The big supermajors all wanted in.Chevron became the operator of the project and owns 47.3%. ExxonMobil owns 25%, whileRoyal Dutch Shell owns 25%.

Seven years later, the outlook for LNG is not as great. Demand from China is no longer as strong because of the country's economic slowdown. Japan's demand might decline as nuclear reactors come back online. Meanwhile, the low U.S. natural gas prices caused by horizontal drilling have led to the potential for massive U.S. LNG exports.

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The confluence of factors has caused LNG spot prices to decline to under $5 per Mcf from the previous double-digit-dollar marks. Making matters worse is that the previous promising environment caused a massive amount of supply to be commissioned, and much of that will come onto the market over the next few years. The additional supply could send LNG spot prices even lower.

The spot-price declines have made selling the long-term contracts harder.Due to the challenging environment, some of the new long-term contracts will provide less revenue. Chevron's older contracts were estimated at 25 years in length and benchmarked to 14.85% of a barrel of Brent crude, with an additional $0.50 to $1 premium.

Now the terms are less generous. Chevron's new deals since December are estimated to be 12.2% to 12.3% of crude oil in addition to a small fee. The deals are estimated to have a floor price and be 10 years in duration.

Higher crude prices will save the project

There is still a case for optimism, however. Although the LNG spot price and crude prices have dissociated, the majority of LNG sales from Gorgon are indexed to crude. The higher crude prices go,the more that those oil-indexed long term contracts earn. Although crude prices are still low, crude prices could rebound substantially because the supply and-demand picture for the commodity has improved. U.S. oil production has fallen around 100,000 barrels per day while OPEC production has dropped because of geopolitical disturbances. Goldman Sachs noted on May 15 that the market is currently in deficit because of the geopolitical disturbances in Nigeria and elsewhere. When excluding the disturbances, many market participants believe the market will reach balance by the end of the year.

The long life of Gorgon is also a positiveMany in the industry believe that demand for LNG is favorable in the long run because of emerging-market growth.Although prices aren't favorable now, the market will improve, as many proposed LNG projects have been canceled and as economic growth in Asia-Pacific countries accelerate again.

The bottom line is that although Gorgon is troubled, the project's long life and the rising crude prices will eventually justify its full-cycle costs. Because much of the capital expense for Gorgon has already been invested, the subsequent cash flow realized when Gorgon comes online this year and next will be very welcome for the three supermajors that currently either barely cover or don't cover their dividends with their cash flow at current Brent prices.